A historical recession (The « green shoots »)

The global economy is experiencing the deepest and longest recession seen since the Second World War. This is because the recession is synchronised and because it has been accompanied by a financial crisis. Fundamentally speaking, it has been caused by the purging of the global imbalances that have accumulated over the past 15 years. As a result, it is affecting both countries with large deficits on their balance of payments that has become hard to fund and now has to be reduced and those running a strong surpluses affected by the collapse in their exports. Business cycle indicators have provided signs over the past few months that the pace of the contraction in economic activity is slowing down (“green shoots of recovery”). “Positive growth” is set to reappear a few quarters down the road. Several factors are pushing in this direction. The headwinds are losing their strength (inventory reductions, stabilisation in home sales following the collapse in prices, stimulus of mortgage refinancing, etc.). Thanks to the measures taken by governments and monetary authorities (capital contributions, liquidity injections, extension of guarantees, purchases of illiquid assets, etc.), financial conditions have eased somewhat after a period of extreme turmoil (narrowing in spreads on the interbank markets and, to a certain extent, in credit spreads, recovery in the stock markets). Even so, it is hard to envisage a return to growth exceeding (except temporarily) potential (though this level is much lower than during the mid-2000s, at barely over 2% in the US and 1% in the eurozone) over the next few years. Firstly, household demand will no longer be sustained by a fresh wave of debt, since the priority is to straighten out balance sheets. Secondly, the effects of the fiscal stimulus policies are set to diminish, barring the assumption the deficits continue to widen! Lastly, the prospects of a modest increase in demand do not bode well for a brisk recovery in investment. Accordingly, the under-utilisation of capacity (output gap, unemployment) will continue to worsen, albeit at a slower pace than in recent quarters, leading to a negative impact on core inflation (excluding food and energy prices). Headline inflation is currently being driven down by base effects linked to the surge in oil prices seen until the summer of 2008. Of course, this effect will disappear in the autumn. The easing in core inflation, a variable that is out of step with headline inflation, will then take over. To date, it has remained relatively inert, notably in the United States, but this is attributable to some highly specific effects notably related to how tobacco products are taxed. Excluding these effects, it has clearly been moving downwards (the cost of medical services grew at a pace of 2.8% y/y in March 2009 compared with 3.7% in 2008, while housing costs–rent–increased by 1.4% compared with 3.2% in 2008). Both trends are thus moving in the same direction. As a result of the deterioration in labour market conditions, the rise in incomes has slowed down significantly, with weekly earnings up 1.3% y/y in April 2009 compared with 3.8% a year ago, and the cost of labour (employment cost index) moved up 1.9% y/y and 0.8% on an annualised basis in Q1 2009 compared with 3.2% y/y in March 2008. The economic contraction during the fourth quarter of 2008 went hand in hand with lower productivity gains (down 0.6% in Q4 after an increase of 2.2% in Q3), leading to a sharp increase in unit labour costs (5.7% after 3.5% in Q3), while the decline in GDP, which was comparable to that in Q1 2009, did not produce the same effects, as productivity increased by 0.8% and unit labour costs rose by just 3.3%, in tandem with the massive workforce adjustments. The improvement in economic conditions will naturally continue to mitigate the increase in unit labour costs, which is a key determinant of core inflation. Inflation is not by any means a concern at present. What matters instead is warding off deflationary pressures. To do this successfully, positive real interest rates must not be allowed to surge. With almost zero nominal rates, inflation expectations need to remain firmly anchored in positive territory (it is also well-known that these form a key determinant of inflation). Running the risk of slightly higher inflation is no doubt the price to pay for avoiding deflation, just as running the risk of a business contraction is the price to pay for addressing the risk of inflation). The increase of the monetary base (the central bank currency), and even its explosive growth in the United States, is not causing any stronger an acceleration in the money supply figures than that seen at the start of the recoveries after the most serious recessions of the past (M2 grew by 12.5% in 1975 and by 13.3% in 1976, by 11.3% in 1983 and by 8.6% in 1984). Indeed, the additional money supply created since last autumn is held by the central banks. Of course, this does not eliminate the risk as economic conditions return to normal that the liquidity will inflate the price of certain assets (including oil). The problem will then be how to mop up the liquidity (exit strategy). The same question will arise in terms of consolidating the public finances. This point will be addressed in a forthcoming article.

The most widespread, longest and deepest recession since the Second World War

As is well known, this recession is global and has been accompanied by a financial crisis. It is the longest and deepest recession since the Second World War (see Chart 1). Only a few economies – China, India, non-oil-exporting Middle East Countries and Africa – will avoid a contraction in GDP in 2009. With its global scope and the accompanying financial crisis, the current recession has all the features to make it both longer and deeper than most past recessions. It will also take longer for economic activity to recover to pre-recession levels, as shown by a recent IMF study of 122 recession episodes, of which 15 were accompanied by a financial crisis. Recessions are considered as synchronised when at least 10 of the 21 advanced economies suffer from a recession simultaneously (Table 2). This recession is hitting both those countries which have a positive balance of payments and those which have a deficit. It is being driven by the elimination of global imbalances. The crisis in the sub-prime mortgage market and in securitisation was not just the result of failures in financial supervision and regulation; it was

also a consequence of the growing imbalances that have been a feature of financial globalisation. The US deficit was easy to finance and capital inflows exerted downward pressure on interest rates. Meanwhile, monetary policy remained excessively accommodating, with the introduction of inflation targeting in a situation where the rising level of imports from low-cost countries and growing competition in the markets for goods and labour made inflation easier to control (opportunistic monetary policy), whilst asset prices were not taken into account unless they fed through into inflation via a wealth effect (no policy of ‘leaning against the wind’) . From the end of last summer, countries with large current account deficits were no longer able to depend on external financing as risk aversion soared and investors needed to sell assets in order to cover losses, creating a wave of capital outflows (Table 3). Under these circumstances the only possibility was a reduction in balance of payment deficits, requiring a contraction in imports that could only come at the cost of a reduction in internal demand; and this indeed is what took place. Naturally this could not happen without a corresponding reduction in exports from countries with a current account surplus. Amongst these, the reduction in GDP growth was greatest in those countries, like Germany and Japan, where growth had been excessively dependent on international trade (see Charts 2 and 3, p. 6). Table 4, which gives data for a selection of countries and regions, shows that both deficits and surpluses have contracted Domestic demand in countries running deficits has fallen sharply. Simultaneously, the contribution of international trade to growth in countries with surpluses (other than China) has also declined rapidly. The adjustment of imbalances is now well under way, and we are nearing sustainable levels of current account deficits. In the US, for example, the deficit shrank from 5% of GDP at the beginning of 2008 to 2.3% in the first quarter of 2009 (see Chart 4, p. 8). Meanwhile, the Japanese surplus, which reached 5.2% of GDP in mid-2007, fell back to 1.4% by the first quarter of 2009. However, a return to sustainable trade balances will not automatically bring an end to recessionary pressures. One also needs to take account of internal dynamics linked to the effects of the output gap, unemployment and incomes on economic conditions. The rapid decline in Japanese exports, which had been boosted by a weak yen, led to a collapse in economic activity and growth prospects which will weigh on domestic demand, investment and imports. In the US, the decline in investment is on a scale that will compress the stock of capital. A return to more normal levels of investment will result in a fresh expansion in the trade deficit. The maintenance of the imbalances at sustainable levels will require a rebalancing of the savings-investment position in countries which are in surplus. This in turn will require substantial structural reforms, such as the introduction of a welfare system in China that will reduce the savings rate, or the reform of the pension system and deregulation of the health system in Japan.

Where are we now? Are we over the worst?

The performance of economic indicators in recent weeks has encouraged a degree of renewed optimism and the markets have been on the lookout for any sign of the oft-discussed green shoots of recovery. However, a number of fundamental factors lead us to believe that the recovery expected next year will, at best, produce a period of lacklustre growth.

Signs and sources of improvement, and their limits.

In the US, the ISM manufacturing index climbed to 40.1 in April (from 35.8 in February) whilst the non-manufacturing index hit 43.7 (from 41.6 in February, when the index started to reverse its decline – see Chart 5, p.8). The rate at which the market for new houses is shrinking slowed (-30.6% year-on-year from -44.6% two months earlier) and consumer confidence rallied to 39.2 (Conference Board Index) from 25.3 in February, thanks to an improvement in the expectations component. Even so, activity indicators continue to point to a contraction. In simple terms, the fall in GDP will be significantly smaller in the second quarter of 2009 than it was in the previous two quarters. Indicators for the euro zone paint a similar picture, with the manufacturing PMI at 36.8 (33.5 in February) and the non-manufacturing PMI at 43.8 (39.2 in February – see Chart 6, p.8). This slight improvement set a number of observers off on the hunt for good news and led to somewhat over-enthusiastic interpretations. For example, it was enough for the number of job losses in the US to fall from 699,000 in March to 539,000 in April for some to conclude that conditions in the labour market are improving – ignoring the fact that the unemployment rate had risen by 0.8 point, to 8.9%, in two months and that the job-loss figures for the previous months had been revised upwards. What is clear, however, is that some of the economic headwinds are easing. A large part of the collapse in GDP in the first quarter (down 6.1% on an annualised basis after a 6.3% fall in Q4 2008) was caused by a violent adjustment in inventories, which knocked 2.8 points off growth. Once excess inventories have been whittled away, one of the major factors driving the contraction of the economy will have been eliminated. Moreover, it only needs the rate of inventory reduction to slow for the contribution of inventories to economic growth to become positive. Deflation (the consumer price index was down 0.7% year-on-year in April) is boosting the purchasing power of individuals despite the slowdown in nominal income growth (wages increased by 4.1% in Q1 2009, after 5.2% and 5.7% respectively in the previous two quarters). Given the improvement in affordability following the collapse in prices (see Chart 7), the residential real estate sector is starting to show signs of stabilisation (see Chart 8). Housing starts have fallen to such a level that the effects of the increased solvency of consumers and demographic factors will combine to stop residential investment making a negative contribution to final demand. House sales are falling more slowly (down 30.6% in March compared to 45.5% in January) and stocks are shrinking (10.7 months of sales in March, from 12.5 months in January for new houses). Although interest rate cuts are unlikely to trigger a fresh wave of borrowing, they are reducing interest costs for borrowers on variable-rate loans. The narrowing of the mortgage spread following the Fed’s purchase of MBS provides an incentive for borrowers to refinance fixed-rate loans, which has the same effect as cuts in short-term interest rates. This process is also driven by the Treasury’s “Making Home Affordable” programme, introduced in February, which encourages the refinancing of standard mortgages (guaranteed or held by Fannie Mae and Freddie Mac), even for borrowers with negative equity, and encourages lenders to modify higher-risk loans (provided that debt service costs are not more than 38% of income). Lastly, although there is no need to stress this point, one also needs to take account of the effects of fiscal stimulus packages. Taken together, this group of factors, plus the recovery in the emerging markets of Asia under the influence of the stimulus measures taken by China, should allow a return to slightly positive growth next year. Several factors, however, suggest that a sustained period of strong growth is less likely. First, there is the action of lagging cyclical variables, notably employment and unemployment. Labour markets will continue to deteriorate for as long as growth remains below trend. However, given that it is unlikely that a new wave of borrowing will fuel demand, as consumers seek to consolidate their financial positions and face a continued negative wealth effect (real estate prices are falling, preventing any withdrawal of liquidity from real estate assets, whilst the recovery in share prices is still a considerable way off wiping out past falls), demand will remain entirely dependent on incomes in a labour market that will continue to languish in the doldrums. The negative output gap (see below) will continue to hold back investment, whilst the recession will increase another lagging cyclical variable, company failures. Lastly, setting aside issues of their effectiveness (strength of the multiplier in a situation where households are rebuilding savings with a view not only to improving their financial situation but also possibly in response to expectations of future tax increases), fiscal stimulus packages will start to drop out of the equation. To prevent this from happening, the stimulus packages would have to be increased on a regular basis, which looks highly unlikely. Thus, according to IMF estimates, US structural deficits corresponding to discretionary measures will rise to 1.4 points of GDP in 2007 to a peak of 4.8 points in 2008 and then ease to 4.6 points in 2009. In the eurozone, the structural deficit will rise from 1.6 points of GDP in 2007 to 3 points in 2009 and will remain at this level in 2010. Inflation and deflation Curiously the markets are worrying simultaneously about inflation and deflation. We focus first on deflationary factors. The scale of the recession is causing widening output gaps, which are setting new post-war records. Even with the recovery expected next year, growth will remain well below potential; the output gap is nearing 10% in the US, Europe and Japan, and unemployment rates will climb to over 10% on both sides of the Atlantic. Under these conditions, the Phillips curves describing the relation between the gap between observed unemployment and NAIRU (non accelerating inflation rate of unemployment) and underlying inflation suggest that there is a considerable risk of the latter moving into negative territory in 2010 (see Chart 15, p.15). Experience shows that recoveries, which naturally induce an acceleration in productivity gains, do not cause inflationary tensions. If we look at the last four American recessions (1973-1975, 1981-1982, 1990-1991 and 2001), goods inflation was running at an average of 4.8% at the end of the recession, 2.7% one year later and 1.9% two years later.

Concerning the United States

For the time being, it is the under-utilisation of resources that is the main determinant of price trends, particularly because this is a global phenomenon. It is all the more likely that underlying inflation will move first into negative territory, close to zero because its starting point is low (1.8% in recent months in the US, from 8% in 1980) and the sensitivity of underlying inflation to the output gap is high when the latter reaches extreme levels (see Chart 15, p.15). It is clear that after the task of getting the credit system working normally, the Fed’s main target is to prevent the highly likely technical deflation (a fall in the index) from turning into real deflation. Real deflation would result from a change in behaviour, with anticipations of falling prices becoming self-fulfilling prophecies: they would result in purchases being deferred, which would hit prices; the real weight of debt would increase, real interest rates would rise (nominal rates being blocked at zero) and this in turn would depress investment. The same would be true for real wages (nominal wages have a certain rigidity on the downside), resulting in falling employment and thence lower demand and prices. In other words we would enter a deflationary spiral. This is not, however, what we expect to happen, given the aggressive economic policies adopted and also because the emergence of deflationary expectations is being held back by the dispersion of price movements (Charts 9 and 10). This dispersion, measured as the standard deviation of movements in the index components, is 4.5 points. This is a level similar to that seen in 2003 when there were fears of deflation which proved after the event to be mistaken. If deflationary expectations are to take hold, it will require price falls across a very broad range of index components. The Fed has doubled the size of its balance sheet since September, and has introduced programmes which could possibly lead to it doubling again. This has resulted in some expressing concern that we see a return to inflation, with too much money chasing too few goods. We believe this is going a bit far. The scale of the output gap is such that it will take several years to close it. At the end of the recession in the early 1980s, it took five years of above-potential growth to do so. The CBO (Congressional Budget Office) does not expect the gap to be closed until the middle of the next decade, and this is based on assumptions tinged with excessive optimism (growth of 4% per from 2010, when a correction in balance sheets is likely to prevent a new wave of borrowing from bolstering consumer spending). For the time being, the explosion in the monetary base (up 89.2% year-on-year in February) has brought absolutely no excessive move in money supply, with M2 up by only 9.7% year-on-year. In other words the money multiplier has fallen and the ratio of M2/Base has dropped, in one year, from 9.1 to 5.3 under the influence of the preference for cash (see Chart 11). In fact, economic conditions are radically different from those in the 1970s, at the time of the last major inflationary wave. Then, even before the oil shock, the price-wage spiral was in full swing and productivity gains were evaporating. Average annual wage rises in the G7 countries ran at 10.9% between 1971 and 1973 and peaked at over 14% in 1974-1975; unit labour cost inflation rose from 7.5% to 13.8%. It is therefore hardly surprising that underlying inflation came close to total inflation (10.4% against 11.1% in 1974-1975), whereas real central bank policy rates fell into negative territory (-1.5%). Since then the economic landscape has been revolutionised by changes in labour markets, the introduction of inflation-targeting policies and the independence of central banks. Lastly, and most importantly, the Fed has a huge range of options if it needs to take a step back. It could suspend its programme of buying up ABS and MBS; it could merely hold the securities it has acquired to maturity without renewing them; or it could rapidly claw back the liquidity created through its TAF, CPFF and ABCP programmes, which all cover securities with a maximum maturity of 90 days. This last group represents one-third of the Fed’s balance sheet and two-thirds of the expansion seen since September 2008. The Fed could also issue its own debt and increase the remuneration of reserves. The question then is when is the Fed likely to return to conventional policy, i.e. raise its Fed Funds target? Taylor’s rule, assuming underlying inflation of 1.5% (in the middle of the Fed’s comfort zone), suggests that the ouput gap will require the Fed Funds rate to be raised in a ‘mere’ four years. However, we would not rule out some action well before this in response to a fall in unemployment, even though econometric estimates of “augmented” Taylor rules including GDP growth or the change in the rate of unemployment do not exhibit significant coefficients for these regressions, nor do they alter the coefficients associated to key variables (inflation and output gap).

And what about the eurozone?

In setting monetary policy, the ECB has used M3 money supply as a key benchmark. The reference growth rate of 4.5% per year has been unchanged since 1999. The underlying analysis on which this approach is based draws on the quantity theory of money: MV= PY or in dynamic terms: ln M(t)-ln M(t-1)= lnP(t)-lnP(t-1)+ ln Y(t)-ln Y(t-1) –ln V(t)-ln V(t-1) M is money supply, V the velocity of its circulation, P the level of prices, Y aggregate output. The choice of the reference growth rate for M3 growth of 4.5% is based on assumed trend GDP growth of 2.25%, inflation of 1.5% and a fall in the velocity of money of 0.75% per year. In fact, M3 growth has consistently run above the 4.5% reference rate. Between 1999 and 2008 it grew by an average of 7.8% per year. This represents a 36% excess in money supply compared to the level that would have been reached if the reference rate had been respected (see Chart 12).

This excess growth did not feed into excessive inflation, other than the temporary effects of oil price shocks. In reality one needs to take account of the impact on M3 of particular circumstances such as portfolio reallocations during flights to liquidity (after the tech-stock bubble burst for instance) which do not bring inflationary pressures. In particular, it is important to recognise that from the middle of the current decade, M3 growth has been driven largely by monetary transactions by non-banking financial agents (adding some 3 points to growth), which, as they do not increase demand, are also free of inflationary effects. What we have seen is a faster fall in the velocity of circulation of money than used by the ECB in drawing up the model that defines target M3 growth. Thus the ratio of nominal GDP to M3 fell from 1.18 in 2004 to 0.97 in 2008. The analysis of excess monetary creation on inflation draws on the P* model which links expected inflation to exogenous shocks (oil prices) and excess money supply. A recent study suggests that a 1% increase in excess money supply produces, over a period of 6 quarters, additional inflation of at most 0.2%. Given portfolio reallocations, the excess increase in money supply comes to 3% per year, generating additional inflation of at most half a point. Is the creation of money by the central bank potentially inflationary? Growth in the monetary base accelerated considerably in 2008, although this acceleration was not seen in either M1 or M3. As a result the ratios of M1/monetary base and M3/monetary base fell from 4.55 to 3.5 and from 10.3 to 7.9 respectively during 2008. The increase in the monetary base came from a change in the behaviour of banks, who lodged excess cash under the ECB’s deposit facility, which creates absolutely no inflationary pressures (see Chart 13). Indeed, the rising number of bankruptcies linked to the recession and the fall in asset values is holding back monetary creation by the banks. In such circumstances, and given the sharp drop in capacity utilisation (see Chart 14), it is clear that a period of slight deflation is a greater threat than a return to inflation.